Factors Controlling Crude Oil Prices (Part 1/3)

Global Crude oil Prices

 There are many factors contributing to the fluctuations in the global crude oil prices. These can be summed under these four headings:

1. OPEC Decisions
2. Impact of Demand and Supply
3. Poor data
4. Other Factors

In the first part we would talk about the role of OPEC in influencing the prices of crude oil. 

1. OPEC Decisions: 

 

OPEC abandoned fixing the reference price in 1987, favoring a system in which OPEC sets production quotas based on its assessment of the market’s call on OPEC supply. Oil prices fluctuate depending in part on how well OPEC does this calculus. Through the process of adjusting its production quotas OPEC can only hope to influence price movements. This adjustment process can prove quite problematic, at times inducing undesired price volatility. 

Given the uncertainties of demand and supply, the lack of reliable and timely data about consumption, production and inventory levels, and the unreliability of short-term forecasts, it is difficult for OPEC to anticipate the direction of the market. 

Even if OPEC predicts the direction of the market adequately, implementing the agreed policy can prove very difficult because of OPEC’s structure. After all this is a coalition of a heterogeneous group of countries facing distinct economic, social and political challenges and with no incentive to share information.

Furthermore, OPEC has no monitoring system to oversee production and shipments and more importantly no punishment mechanism to deter cheaters. This structure, in which agreements are reached at the last minute and concluded on the basis of compromise rather than optimizing decisions, generates considerable uncertainty about supply conditions, contributing to oil price volatility.

OPEC decisions play a major role in global crude oil prices

In this respect, it is interesting to note that implementing output adjustment is problematic both in the face of falling and growing global oil demand though for different reasons, i.e. OPEC’s response is asymmetric to global demand conditions. If global demand for oil falls, non-OPEC suppliers will continue to produce. They usually wait for OPEC to make the decision of how much to cut and which country must undertake these cuts. Because of OPEC’s structure, these are very difficult decisions to make and implement in face of a falling market.

Furthermore, expectations of output cuts induce speculation about OPEC’s ability to adhere to them. These expectations can cause swings in net speculative positions and reversal of such positions if the cut is less than expected or does not materialize.  In the case where global demand for oil rises, although agreements to increase quota are easier to reach and implement, OPEC may not respond quickly to this upward trend, especially in an environment of imperfect information. After all, the decision to wait and not increase output is much more profitable than to increase output if the trend turns out to be false. The slowness of the response to an upward trend can contribute further to volatility by under supplying the market.

In Part 2 we would talk about What happens to oil prices when Demand and Supply of petroleum and its products vary ? 

Note: this topic is under three parts - Part 1, Part 2 and Part 3  (click to see the all three parts)

 

Posted in: Petroleum Management,Pricing